Including updates on crowdfunding and MiFID II

Regulating Crowdfunding

Crowdfunding took a step into the mainstream this month when the European Commission (EC) launched a consultation exploring ways to support the development of this innovative finance alternative. Crowdfunding can take many forms. One popular type, known as peer-to-peer lending, enables borrowers to tap loans directly from savers through internet-based platforms. Crowdfunding has the potential to bridge the financing gap for many start-ups and provide much needed returns for yield-strapped investors grappling with the low interest rate environment.

This rapidly growing sector claims to offer a better deal than traditional banks or venture capital houses by cutting out the ‘middle man’. While crowdfunding platforms often charge a fee to assist with publishing campaigns and collecting funds, those charges are usually small compared to the margins that banks or other finance providers require.

Crowdfunding platforms themselves are attracting more serious investors in their own businesses – another sign that they are becoming mainstream. Google recently paid £125m for a 7% investment in the Lending Club, a peer to peer lender. Philips and Vodafone have recently invested in crowdfunding, running competitions to foster innovation and offering matching loans. The UK arm of Santander is in early talks with Funding Circle – one of the largest peer-to-peer lenders – to join forces on loans to small and medium-sized businesses. While teaming up with banks may undermine the sector’s credibility as a true alternative to traditional lending, more lenders are required as demand for crowdfunding loans are beginning to vastly outstrip supply.

In 2012, crowdfunding in Europe grew by an estimated 65% compared to 2011, reaching €735 million. This growth is promising compared to the shrinking European venture capital market of €3 billion, but is still small compared to the European initial public offering (IPO) markets of around €16.5 billion. The UK has the most advanced crowdfunding market in Europe. In the last three years crowdfunding has trebled in size in the UK–exploiting the gap left by banks retreating from lending. The UK market could be worth £1 billion by 2016, according to the Open Data Institute, if it continues to grow at its current speed.

Crowdfunding presents some promising opportunities for European businesses but also some potential risks for investors and financial markets. Start-ups find it difficult to raise funds – the odds against creating another ‘Google’ or at least a viable business often seem to be stacked against entrepreneurs. Do small crowdfunding investors really understand the risks they are taking? Banks with advanced credit risk systems and deep pockets are likely to be in a better position to assess risks and bet on nascent businesses than individual investors. There are also risks of fraud (i.e. when the money collected is not used for the stated purposes), misleading advertising or other shenanigans suckering unsuspected investors.

Some of these risks can be alleviated by effective regulation which could help boost the fledgling industry and add legitimacy to new online finance models. First out of the blocks, the US Security and Exchange Commission (SEC) published 585 pages of proposed crowdfunding rules on 23 October 2013. The SEC was mandated by Congress, as part of the 2012 Jumpstart Our Business Startups Act, to look at loosening certain restrictions to make it easier for small companies to raise capital on internet platforms. It grappled for a year on how to hit the right tone but has finally decided that intermediaries can rely on investors to vouch for themselves in terms of appropriateness (subject to some restrictions on how much a person can invest). This development is seen as a major win for crowdfund operators.

The new rules also introduce pretty run-of-the-mill transparency requirements for businesses seeking investment. Budding ‘Starbucks’ would be required to provide information to prospective investors about their business plan and financial condition as well as a list of significant investors. The new rules have won praise from lawmakers and crowdfunding operators alike according to press reports and could fundamentally change how start-ups are financed in the future.

The UK may be on a similar path. Its financial conduct regulator, the Financial Conduct Authority (FCA), published a consultation paper on its regulatory approach to crowdfunding and similar activities (CP13/13) on 24 October 2013. The FCA proposes to change its regulatory approach to make the market more accessible to retail investors, develop competition and facilitate access to alternative finance options. But the FCA wants to ensure that only investors who are able to understand and bear the risks participate in the market. The FCA therefore proposes to allow firms to use crowdfunding platforms to promote investments to some categories of retail investors.

But can the UK, or any individual EU country, create a sufficiently liquid market? Do we need a pan-EU crowdfunding market? The EC seems to think so. It is exploring how EU action, including a range of soft-law measures, could promote crowdfunding. Its ultimate objective is to gather data about the needs of market participants and to identify the areas where encouraging the growth of this new industry adds value, either through facilitative, soft-law measures or legislative action. The EU consultation covers all forms of crowdfunding, ranging from donations and rewards to financial investments, and is open until 31 December 2013.

The EC needs to thread carefully here. Regulation has the potential to kill off this business model entirely but the lack of regulation could have the same effect. Introducing appropriate safeguards makes sense to ensure that investors are fully aware of the risks that they are taking. As long as regulation is designed to make market processes work better (i.e. matching small investor’s needs with crowd financiers’ risk and return appetite) it will help develop this industry, preserving its complementary nature to traditional bank lending and capital markets. Investors – banks and other institutional investors, venture capitalists, angel investors - may provide valuable insights on how to frame appropriate regulatory protections while ensuring this embryonic industry flourishes. Brussels wants to work harder to ensure growth. Crowdfunding is an easy win for politicians but likely to remain a small source of funding for the foreseeable future. Lack of finance is only one challenge facing EU businesses - EU politicians are also working to help business by implementing challenging structural reforms in the labour market, trying to cut red tape and harmonising insolvency laws across borders.

MiFID II on the horizon: a tectonic shift

Negotiations on the new MiFID II/MiFIR (MiFID II) regime entered their crucial, final phase in July 2013, following a hard won agreement in the Council on its general approach at the end of June. The EP, having reached its own negotiating position in October 2012, had been putting pressure on the Council for some months to agree its position as concerns grew about legislators’ ability to finalise the text before the EP elections in May 2014.

Indications now are that MiFID II is near the top of the negotiating priority list (although lagging slightly behind Banking Union related measures) and that the EU legislators all buy into the target of reaching political agreement before the end of this year. The EP plenary vote is currently scheduled for 10 December. Feedback from Brussels suggests that negotiations are proceeding quickly and that trilogue negotiators have identified all key political issues. But the difficult bit is still to come: in a number of areas the legislators’ views diverge significantly and precarious compromises reached in both the Council and the EP will need to be revisited.

The remaining contentious areas focus on striking an appropriate balance between market efficiency and market stability or safety. Three of the four issues relate to how best to calibrate this balance. But the fourth issue marks a fundamental difference in philosophy and may be much more difficult to resolve.

MiFID II has been designed to address issues highlighted during the financial crisis, not least the impact that technology continues to have on the way our markets operate. Central to this problem is the upsurge in electronic trading. Policy makers have identified two issues here: the proliferation of different types of electronic platforms and the development of different trading methods based on various forms of computer algorithm. These two issues are intertwined but centre on the future treatment of trading platforms that currently fall outside the definition of a ‘regulated market’ (RM) or ‘multilateral trading facility’ (MTF).

The EC proposed that all forms of electronic trading platforms should be swept up into a ‘catch all’ category called ‘Organised Trading Facility’ or OTF but that such platforms would be left with a certain amount of discretion in terms of how the platform operates and who could access it. But both the Council and the EP have concluded that a ‘one-size-fits-all’ approach to OTFs will not work, particularly considering the different roles they play in different markets, and believe that there should be differentiation. The EP would like all equity trading to take place on RMs or MTFs whereas the Council wants to retain a possibility for OTFs in all markets but restrict the additional flexibility of ‘matched principal’ trading to non-equity OTFs. Given the intensity of negotiation on this issue in both the Council and the EP, aligning these two positions will not be easy.

MiFID I significantly increased the transparency of equity markets, introducing common pre-trade transparency requirements. MiFID II looks to reduce the number of situations where pre-trade transparency requirements in the equities markets can be waived, while simultaneously introducing equivalent transparency requirements for non-equities. But without the ability to screen their trading activity from the full glare of the market, some market participants, such as pension funds, could be severely penalised. That in turn could cause significant costs and even losses to the end-investors. Four types of pre-trade waiver were permitted by MiFID I. The EC proposed reducing and narrowing the number and type of possible waivers, an approach which was broadly supported by the EP. The Council, after much debate, decided to retain the four types of waiver but to limit their use through the introduction of a volume cap on those waivers based on reference prices. The difference between the Council’s and the EP’s positions on this issue is not an essential difference in philosophy but rather a question on how to strike the right balance.

When MiFID I was being negotiated, some commentators argued that the way MTFs were to be regulated would result in market fragmentation rather than enhancing competition. This criticism has been partially borne out. The removal of the ‘concentration rule’ encouraged active competition but also resulted in data fragmentation, reducing the positive impact of a more open market infrastructure on market efficiency. This situation has led to an increased focus in the MiFID II proposals on post-trade transparency requirements, not least the introduction of a ‘consolidated tape’ for the equity markets and in time for the non-equity markets.

Some parallels can be drawn between this debate in MiFID I and questions around non-discriminatory access to CCPs and trading venue data in MiFID II. Here the debate centres on creating a single EU market that permits different business models while protecting competitive integrity and investors. This issue proved the most difficult to resolve in the Council and the precarious compromise reached leaves little room for negotiation with other trilogue participants. Although close to the EP’s position, the Council wishes to introduce a three-year transitional period for newly established CCPs and trading venues during which they will not be obliged to comply with MiFID II requirements. Essentially, though, the Council’s position adheres to the fundamental EU philosophy of open markets.

The same cannot be said in relation to the openness of EU markets to the rest of the world. The EC proposed introducing an ‘EU passport’ for firms from countries outside the Union through the establishment of a branch in one Member States of the EU. Again, the EP broadly supports this approach. The Council, on the other hand, rejects the idea of a passport, preferring to retain the status quo - which requires that foreign firms establish branches in every Member State in which they wish to operate. This fundamental difference will be difficult to resolve. But in the short- to medium-term, firms already established in the EU will not be significantly affected whichever way this issue is resolved.

Other controversial issues where negotiating positions diverged at the outset include the treatment of high frequency trading, position limits and management for commodity derivatives, corporate governance, product intervention, investor protection measures (including telephone recording), and restrictions to inducements and the concept of ‘target markets’. All or any of those issues may affect the way EU markets operate in the future. The next few months of trilogue negotiations between the Council, the EP and the EC will be challenging for the negotiators but compromises should be possible.

In terms of next steps, legislators are aiming to reach political agreement on the MiFID II Directive and MiFIR by the end of this year - a key milestone but not the end of the process.

After political agreement, the EP has to adopt the text in plenary session. The indicative date for this vote is currently 10 December 2013 but this vote must postponed unless political agreement can be reached by mid- to late-November - a target which appears ambitious. Political agreement marks the end of political trilogues but not necessarily the finalisation of technical matters, which may overrun into next year. After the plenary vote, the EC carries out a review assessing the texts’ compatibility with EU law and the quality of translations. Then the Council formally adopts the text and it is published in the Official Journal. If political agreement is reached in December, it is possible that the text will enter into force by late Q2 2014.

In terms of the Directive, its entry into force triggers the two year transposition period for Member States. In addition, the Directive delays implementation for a further six to eight months after the transposition period. From the outset, the EC has said that the full regime – the Directive and the Regulation – should be applied from the same date, a position with which the Council agrees. But the EP would like MiFIR to apply a year earlier (i.e. 18 months after entry into force). This issue should be resolved during the trilogue negotiations.

MiFID II is likely to apply from Q4 2016, which sounds like a long time away. But don’t take this as a three year reprieve - MiFID II, together with other market-changing measures like EMIR and the Central Securities Depositories Regulation and a host of other legislative changes, represent a fundamental overhaul of the EU financial markets. Many firms have already begun analysing the impact these changes will have on their products, services, operations, systems, etc. Market leaders recognise the tectonic shift in our markets that is coming – and they are already integrating that analysis into their business strategy.